The Rise of Shadow Banking

Posted in Finance Articles, Total Reads: 1836
, Published on 09 October 2014

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Mark Carney, Governor of the Bank of England and head of FSB (Financial Stability Board), an international agency formed to guard against financial crises, was recently asked to point out the greatest danger to global economy. His answer was ‘shadow banking in emerging markets’. Shadow banking is certainly a global bogeyman, being huge, fast-growing and little understood. The FSB reckons that shadow banking constitutes a quarter of the global financial system riding on assets worth $71 trillion at the beginning of 2013, a humungous increase from $26 trillion a decade earlier. It is expanding even faster in some emerging countries like China where it grew by 42 percent in 2012 alone.

A broader definition of shadow banking is ‘any bank-like activity carried out by a firm which is not regulated as a bank’. An example could be mobile-payment platform offered by Vodafone. The argument is not about new competition against banks, but about credit quality. Banks are regulated in all economies due to certain reasons: their high maturity mismatches, enormous leverage and linkage in complicated ways with other financial institutions. And when they fall into trouble, governments often guarantee deposits to avoid failure of financial security of the country. Tight regulations framed as part of Basel norms in many countries aim to make such incidents impossible. Banks are advised now to device structured investment vehicles on balance-sheets, hold reserve liquid assets and be more honest.

Image Courtesy: freedigitalphotos.net, Keattikorn

The shadow banks which caused problems in the past had neither maturity mismatches nor adequate reserve capital to contain losses. The biggest danger lies in China, where regulatory arbitrage exists on a huge scale. Banks in China are banned from extending credits to certain industries and attracting deposits by promising high returns. This encourages emergence of shadow banks of various sorts as many firms are setting themselves up as pseudo-banks. Although it is hard to believe that the shadowy credit to unprofitable steel mills and property developers would pay off, investors piling in deposits over the shadow banking firms.

It will not be an overstatement to say that China’s shadow banking system is an enormous beast. It flourishes outside the regular lending channels beyond the control of China’s regulators. The business volume of shadow banking has reached a whopping $4.4 trillion which is 20 percent of the country’s total bank assets. This scale is substantial enough to compete with the formal banking system and broad enough that it is a key economic factor for the world’s second largest economy.

Interestingly, China’s shadow banking system is migrating online. It now boasts about 2,000 websites offering peer-to-peer (P2P) transactions. People can now lend money online to strangers for any purpose- say a new car or a wedding dress-and enjoy rates of interest around 20 percent, significantly higher than the 3 percent offered in a traditional savings account.

P2P acts as a platform to cater demand and supply quick funding especially for sections excluded from formal lending system. It got wider audience after the country tightened credit issue in 2010 to counter the effects of the global financial crisis. The interesting point is that the default rate on P2P loans is only marginally higher than NPA reported by formal financial institutions. Internet finance is a wake-up call to the formal financial institutions given the creditworthiness displayed by the shadow banking model in China. P2P lending is also raising the cost of acquiring funds for banks. This in forcing established lenders to adopt interest rate liberalization and experiment new business models. The People’s Bank of China (PBOC), the country’s main regulator now seeks to impose regulatory authority over the sector and build consumer protections measures but it’s highly unlikely that it will unveil regulations for internet financing anytime soon due to high risk involved in disturbing a major driver of growth.

Wealth Management Products are the major group of higher-yielding investment products and are known as Easy Heaven Investments. The major attraction luring investors here is high returns which is around 9%-12% compared to bank-deposit rates of 3%-4%. Transactions of WMPs are done through banks or brokers. Investment periods are typically short and are invested in a range of assets, from low-risk interbank loans to high risk securitized debt. The loan growth in formal banking sector has increased at a higher rate than deposits since deposits in WMPs became more popular (Figure 1).

One reason why WMPs offer higher interest rates is that they invest in riskier assets. Banks do not hold shadowy loans on their balance sheets nor did they set aside reserve capital as they typically extend credit via intermediaries called trust companies. China’s reserve requirement ratio (RRR) is 20 percent, which puts a limit on the amount of credit that can be created. Since WMPs operate off balance sheets RRR do not apply thus giving potential to create lot more credit than banks.

Ironically, China’s regulated financial system itself had given rise to shadow banking. The credit market is dominated by the big four state-controlled banks which focus on lending money to State Owned Enterprises. Other businesses have very limited access to bank credit market and are catered by shadow banking system. Government regulation on deposit interest rates has also helped shadow banking. The bank deposit rates have been below inflation for a long time. Negative returns and loss of purchasing power led people to seek higher rates from shadow banks. The government has also curtailed credit expansion by decreasing loan quotas, restricting lending to certain sectors and limiting risky transactions. This has encouraged the growth of the shadow banking sector.

To conclude, the shadow banking system in China illustrates a popular Chinese saying: ‘Shang you zhengce, Xia you duice’ which means that when policies are formed at higher level, people at lower levels will definitely find ways to get around those. This is a real crisis in evolution. A major policy turnaround will be essential to counter the alternate banking system. The government can make use of use formal banks to tighten its control and it has ample cash to settle things out. But the results will be realised at a huge cost.